Low Volumes And High Operational Costs May Hamper Norfolk Southern’s Earnings

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Norfolk Southern

Norfolk Southern (NYSE:NSC), one of the leading railroads in the eastern U.S., is scheduled to report its first quarter 2014 results on April 23. Similar to other railroads, we expect the company to have faced pressure on its operating expense due to weather related disruptions. Additionally, shipment volumes negatively impacted by the weather conditions, will be low and have an unfavorable impact on revenues. In order to offset the impact of decreased volumes, Norfolk Southern’s average revenue per unit will have to show a considerable increase. Given that the company’s average revenue per unit has always increased sequentially from the fourth quarter to the first quarter, primarily due to scheduled re-pricing of contracts, we have similar expectations for this quarter as well. The only question that remains is whether the increase in average revenue per unit will be enough to offset volume declines and help increase revenue.

See our complete analysis of Norfolk Southern here

Revisiting Fourth Quarter 2013

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Norfolk Southern revenue for the fourth quarter grew by 7% to reach $2.9 billion driven by growth in its merchandise and intermodal business which more than offset declines in coal shipments. [1] Revenue per unit volume improved by 3% in the fourth quarter due to improved pricing and increased fuel surcharges.

The company’s net profits increased 24% year-on-year in the fourth quarter to reach $513 million driven by overall volume growth, which outpaced the increase in operating expense. This resulted in a 4% decline in Norfolk Southern’s operating ratio (operating expense expressed as a percentage of revenues). Operating expenses grew only 1.5% compared to volume growth of 4% due to an increase in compensation and incentive costs and fuel expenses.

Weather Related Disruptions May Drive Up Costs

Norfolk Southern had to employ additional resources to maintain proper functioning of services through the difficult winter weather. These included increasing employee and locomotive count. [2] Increase in employee and overtime will directly impact compensation and benefits costs. Fuel and purchased services & rent expenses will be driven up by the increased locomotive count.

Additionally, Norfolk Southern’s performance metrics, such as terminal dwell and average train speed, have performed badly due to the severe weather. Terminal dwell, which indicates the average time a freight car resides in a terminal, has increased 13% year-over-year and average train speed has decreased 8%, [3] both unfavorable directions of change which will impact operational costs.

Low Volumes Of Merchandise And Coal Shipments Will Impact Revenue

Norfolk Southern’s carloading report for the first quarter reveals that overall merchandise shipments have declined 1.2%. [4] Declines in merchandise shipments such as automotive and parts, chemicals, lumber, wood, paper and pulp, rice and refrigerated products are primarily on account of the severe weather. The few commodity shipments that have increased in the first quarter include grains such as corn and soybean, crude oil and liquid petroleum gas, stone, clay and glass products. Growth in corn and soybean shipments has been driven by the strong harvest in the U.S. last year, which boosted corn production by 30% and soybean by 7%. [5] Crude oil and liquid petroleum gas production continues to grow driven by the shale boom. Crude oil production in the U.S. has increased from 6.48 million barrels per day in 2012 to 7.44 million barrels per day in 2013. [6]

Norfolk Southern’s coal shipments have declined 13.8% in the first quarter. We believe the decline is mostly related to the slow demand for U.S. coal in the global markets, leading to a decline in Norfolk Southern’s shipments export coal. Export coal accounted for 19% of the total coal tonnage for Norfolk Southern in 2013. U.S. coal is facing pressure from declining global coal prices due to the oversupply created by the comeback of Australian coal producers and declining demand from China. However, domestic coal demand is increasing due to rise in natural gas prices and declining inventories at utilities. Coal inventories at utilities have declined from 185 million short tons in 2012 to 148 million short tons in 2013. [7] This may have increased Norfolk Southern’s shipments of domestic coal for the first quarter 2014.

Decline in merchandise and coal volumes will negatively impact revenue unless offset by growth in revenue per unit. Revenue per unit for merchandise shipments have increased year-over-year since 2011 and we expect the trend to continue in the first quarter 2014 given the improving economic condition of the U.S. and improvements in the end markets for merchandise commodities. Coal revenue per unit has been declining since 2011 and may add to the pressure on the top line in the first quarter.

Intermodal Shipments Growth Will Have A Positive Impact On Revenues And Volumes

Volume of Norfolk Southern’s intermodal shipments have been increasing year-on-year and quarter-on-quarter since 2011. In the first quarter 2014, Norfolk Southern’s intermodal volumes increased 3.4% driven by the new  inland port in South Carolina and the new terminal in Charlotte, both inaugurated in the fourth quarter 2013. [4] The company has been able to achieve growth for the past few years due to its strong commitment towards expanding intermodal capacity.

Growth in revenue per unit for intermodal shipments has been limited by the ability to re-price contracts since contracts are based on one whole year. Hence, Norfolk Southern has not been able to take advantage of the favorable conditions that developed in 2013, including the new hours-of-service safety regulation for truck drivers and improvement in the economy. Given that Norfolk Southern renegotiates contracts during the first quarter of the year, we can expect to see some improvement in the revenue per unit this quarter. Combined with growth in volume, we can expect to see an increase in revenue from intermodal shipments.

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Notes:
  1. Norfolk Southern Quarterly Financial Review, Jan 22 2014, www.nscorp.com []
  2. Norfolk Southern’s BB&T Capital Markets Transportation Conference, February 12 2014, www.nscorp.com []
  3. Norfolk Southern’s Weekly Performance Report, www.railroadpm.org []
  4. Norfolk Southern Carloadings Report, www.nscorp.com [] []
  5. National Agricultural Statistics Service – Crop Production, www.usda.gov []
  6. Short Term Energy Outlook – Oil, April 8 2014, www.eia.gov []
  7. Short Term Energy Outlook – Coal , April 8 2014, www.eia.gov []